A Rationale for Continued Deregulation of the Banking Industry

The Economic Report of the President argues that continued deregulation of the banking industry would serve to allocate credit more efficiently and promote the health of the nation's financial system.

In particular, the report calls for dismantling state barriers to bank expansion, permitting out-of-state banks and other financial institutions to buy failing thrifts, and relaxation of limits on investment and lending activities.

However, that free-market philosophy also lends itself to supporting measures such as risk-based deposit insurance premiums and risk-based capital requirements, which would the report argues, impose market discipline.

The report, from which the following excerpts were taken, was prepared by the President's Council of Economic Advisers and delivered to Congress on Feb. 6.

INSURED DEPOSITS IN COMMERCIAL banks, thrift institutions, and credit unions now stand at more than $2 trillion, making deposit insurance by far the largest of the federal guarantees in the credit markets. Deposit insurance is intended to prevent runs on these depository institutions (here called "banks" when discussed as a group) that can degenerate into general banking panics.

Runs occur when depositors become concerned that an institution's assets may not be able to ocver all of its deposits. Depositors "run" to be first in line to withdraw their deposits. Because the typical bank's assets are for the most part illiquid, even a bank whose assets are larger than deposits plus other liabilities can have considerable difficulties in accommodating large, sudden withdrawals of deposits.

From the point of view of averting runs, it does not matter whether a deposit insurance corporation stands ready to make deposits good or a lender of last resort is ready to lend to institutions plagued by runs, so long as depositors believe that the backer will support the deposits.

Assuring this support is a particularly difficult problem for deposit insurance. Conventional insurance -- for example, life insurance -- operates on the principle of insuring many uncorrelated risks. But bank runs tend to be contagious. The only insurer that unambiguously has the capacity to meet any run, no matter how large, is one with the power to print money. This gives the government a comparative advantage in providing deposit insurance.

The role of deposit insurance is not so much to pool, diversify, and eliminate risks, as conventional insurance does, but to change the way in which certain risks are borne. While there is a large diversifiable component to lending risk, there remains a large, nondiversifiable component that simply must be borne.

Without deposit insurance, the risk is borne by both equity holders and depositors, leaving the banking system vulnerable to occasional collapses through runs. With deposit insurance, the risk is borne by bank equity holders and the public.

Deposit insurance imposes risk on the public because it prevents loss to depositors, not only from runs on solvent institutions but also from defaults on loans and, if the maturity of the bank's assets and liabilities are not matched, from changes in interest rates. Without the inherent uncertainty regarding the value of bank assets, there would be no reason for runs. Thus, maintaining deposit insurance requires insuring against these events, as well as against mere illiquidity.

When a banking is insolvent as a result either of defaults on loans or of fluctuations in interest rates, the loss may be treated several different ways.

First, it could be met by an insurance fund capitalized with insurance premiums. Should the loss exhaust the fund, the additional loss could be borne either by collecting taxes to pay off depositors or by printing money to pay off depositors.

If printed money is the solution, the cost is borne in the form of a general rise in the price level. …

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